How Safe Are Data-Storage Stocks?

January 08, 2001

By Amey Stone Companies that sell hardware and software to store growing mountains of data are supposed to be one of the stock market's safe havens. The idea is that data storage isn't something a company can decide to cut -- anymore than it can decide to stop keeping records of legal documents, corporate e-mail, or personnel files.

"Storage is always in demand," says Alex Aydin, chief financial officer of Procom Technology (PRCM), who sees no slackening in demand for the network-attached storage equipment his company sells. "You consume it, and you need to buy more of it. It's like paper." That may be true, but storage hasn't escaped the tech carnage. While demand for storage software and equipment is still robust, there's no safe haven in the current harsh market environment. Technology investors are spooked by repeated earnings warnings and confused about the impact of the Federal Reserve's surprise half-point rate cut on Jan. 3.

The typical storage stock, including such 2000 market stars as EMC (EMC), Network Appliance (NTAP), and Brocade (BRCD), is around 40% off its high. For the first two weeks of 2001, these stocks have been particularly volatile, rising 20% one day, only to drop 20% the next. For example, storage king EMC, which is expected to do $12 billion in sales this year, ended the year at $66.50 on Dec. 29. It closed the first day of 2001 trading, on Jan. 2, at $54.31 and ended the day of Jan. 3 at $67.81.

SWOONING IN SYMPATHY. Many analysts believe storage stocks -- still not cheap when judged by their price-to-earnings multiples -- could decline further in sympathy with the rest of technology, even if demand for their products stays strong. Many of the fastest growing storage companies, like network-attached storage leader Network Appliance and software maker Veritas (VRTS), have forward p-e ratios of more than 100 (the multiple of the Standard & Poor's 500-stock index is 21). Those could still come down. And if the Fed rate cut proves to have been too late to shore up the slowing economy, even storage companies will be hurt as activity slows enough to reduce businesses' data-storage needs.

Wall Street, uniformly bullish on the sector until recent days, is sending conflicting signals. On Jan. 2, Robertson Stephens analyst Dane Lewis downgraded the storage sector -- as well as Internet security stocks -- because he believes info-tech spending is slowing so dramatically it will affect spending on storage. He believes stocks could fall when analysts have to ratchet back their estimates for some companies and leading companies report results that are only in line with analysts' expectations. "Multiples will follow spending trends to lower levels," Lewis wrote.

Then on Jan. 3, Merrill Lynch analyst Tom Kraemer reaffirmed his buy ratings on Brocade, EMC, and Network Appliance. "Most of tech has been massacred," he wrote to investors. "But our data suggest that storage may weather the storm better since its earnings stream will be more reliable than almost any other area of technology." The same stocks that plummeted on Lewis' report rebounded nicely thanks to Kraemer's.

The Fed rate cut also lifted the group while adding to the overall confusion. "My view of the rate cut is that it really removes the recessional fear that overhangs the whole market," says Scott McClendon, CEO of Overland Data (OVRL), which makes equipment for backing up corporate networks. He believes the rate cut will give investors faith that businesses really will continue to spend on storage equipment -- which he thinks they would do anyway. "It restores confidence that companies are going to be able to buy," he says.

Robertson Stephens' Lewis, who says he "loves" storage stocks long term, says the rate cut doesn't change his near-term concerns. "It validates my fears about first-quarter spending. But it does make me feel better about the second half."

The sector leaders are the most predictable and thus may be the safest bets

Buying on the dips in the first part of the year to benefit from a stronger second half -- when the Fed rate cut should start to work its magic -- seems to make the most sense now. But be ready for bumps. "I would be buying these storage stocks," says A.G. Edwards analyst Shelby Seyrafi. He says 90% of his concern is about valuations falling, while only 10% of his worry has to do with an information technology spending slowdown. He recommends investors go with leaders like EMC, NetApp, Brocade, Veritas, Emulex (EMLX), and Qlogic (QLGC). "I think we're going to have a bumpy ride until the next Fed rate cut." He expects that to happen at the central bank's Jan. 31 policymaking meeting.

None of the leading storage companies have contributed to the slew of earnings warnings lately, points out FAC/Equities analyst Mark Kelleher, who adds: "I keep saying, 'knock on wood.'" He recommends investors stick with the leading companies, which are the most predictable, including NetApp, EMC, Emulex, and Brocade. "Any pullback is a good time to get in," says Kelleher. "They have some of the best growth rates and the best visibility."

MATURING TECHNOLOGY. That doesn't mean the leaders have no worries. EMC is facing continuing competitive pressure as computer hardware companies, such as Sun Microsystems, IBM, and Hitachi, place more emphasis on storage products. "We're seeing some of their competitors getting their act together," says Seyrafi. EMC will also be the most vulnerable as storage ultimately follows the path of all new technology: competition leads to pricing pressure as revolutionary products become commodities. "As [technology] matures, prices come down, and valuations of stocks come down," says Robert Burgoyne, technology strategist at Monument Funds.

But both Procom's Aydin and Overland Data's McClendon say the high-tech data-storage solutions being sold today are so new and in such high demand that investors needn't worry about competition and pricing squeezes.

Network Appliance, another favorite storage stock, has faced extra pressure recently because about 8% of its revenues come from "caching" servers, which are used to speed up data retrieval across the Web. Software maker Inktomi (INKT) warned on Jan. 3 that it would miss analysts' first-quarter estimates because of weakness in its caching software sales, prompting worry about this small segment of NetApp's business.

For investors with a six-month time horizon, data storage is hardly a haven from the ongoing turmoil in technology markets and the broader economy. But if storage leaders continue to be volatile, the first half of the year could prove a good time to make a long-term bet on this industry: Its growth prospects further down the road seem safe indeed. Stone is an associate editor of Business Week Online and covers the markets in our daily Street Wise column.